T. Boone Pickens, shown making a speech in March about the future of the oil industry. (AP)

Speculators – not supply and demand – are to blame for skyrocketing gas prices

COMMENTARY | July 11, 2006

A bipartisan Senate report, largely ignored by the media, says that there's no oil shortage and none is expected. Rather, it's massive, unregulated speculation that is costing consumers billions of dollars – and vastly enriching people like T. Boone Pickens.

The conventional explanation for high gasoline prices doesn't work. The notion that energy demand, especially in places like China and India, created a world-wide oil supply shortage which drove up prices and caused Americans to pay more at the pump cannot be squared with the facts.

On June 26, the Senate Permanent Subcommittee on Investigations issued a report on the role of market speculation on the prices of oil and gas that leaves the accepted wisdom in need of stark revision.

The report was barely touched on in the news media but its analysis of petroleum prices demands serious attention. This story is far too important to be left lingering on the back pages of the trade press. Petroleum prices deserve better than a mere repetition of the high-demand-low-supply theory, particularly when it is conspicuously inconsistent with the facts.

[Click here for a press release describing the report;click here for the report.]

The first point of the PSI report is that, while there has been a growth in demand, there has also been a growth in supply, hence no shortage. In fact, global oil supply has generally exceeded demand in recent years. As a result, commercial crude oil inventories have been rising.

Nor is shortage anticipated. The report quotes the International Energy Agency as saying that “additions to OPEC and non-OPEC capacity are forecast to keep global supply broadly in line with demand in 2007 and 2008." Likewise, the Department of Energy forecasts that global surplus production capacity will continue to grow to between 3 and 5 million barrels per day by 2010, "substantially thickening the surplus capacity cushion."

The second point is that the amount of crude oil in U.S. commercial inventories has been above average over the past year. The amount of natural gas in storage, except for a short period following Katrina, has been above its previous five-year average. The Department of Energy projects that natural gas inventories will also continue to grow in 2006.

If a shortage did not cause the high prices, what did happen? Here is where things get a bit complicated. What follows is a brief and somewhat simplified guide through the more important concepts in the report.

There are two ways to buy petroleum. One can simply buy it now, and pay for it at the current price. Or one can contract to buy it later at a future date, and pay for it at a price which reflects its future value. This future price will usually be different from the current price. Usually it reflects a premium that one is willing to pay in order to ensure a future supply and it reflects the parties' expectations about future prices. It has the advantage of locking in a price, thereby providing a "hedge" against an unexpected future price increase. (Futures markets also provide the means of hedging against falling prices.)

There are two kinds of buyers of petroleum: oil companies who need it for their refineries, and speculators who are simply looking to make money on trading. Oil and gas companies, of course, have facilities for handling deliveries: terminals, storage capacity, etc.; speculators do not.

Historically, there has been a simple and direct relationship between the amount of crude oil in inventory and the price. The more crude oil in storage, the lower the price. This was a simple supply-demand relationship. The same was true for natural gas. This simple and predictable relationship changed in 2004: higher inventories were suddenly associated with higher prices. This reversal of the normal price-supply relationship coincided with a massive influx of speculative money into the crude oil and natural gas futures markets. By one estimate, over $60 billion has been spent on oil futures in the NYMEX market alone over the last few years.

This massive infusion of speculative money in the crude oil and natural gas markets has changed the behavior of the players in the market. By one analysis, long-term futures prices have pushed up the longer-term prices to the point that it is more profitable for oil companies to hold oil to sell at a later date even in the face of current high prices. This has increased the demand for oil and gas in storage. The report uses an example: "Even if oil is at $70 per barrel today, suppliers will hold their inventories if they can sell it for $75 for delivery a year from now."

In effect, the speculation has increased the demand for oil and gas. As the report found, "As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum."

It is important to note here that speculation is not necessarily bad. On the contrary, some level of speculation is necessary to make markets work smoothly and efficiently. Without some speculation markets can be sticky and thin, subject to manipulation. To use the proper term, speculators provide "liquidity." For everyone wanting to avoid a price risk, they provide someone willing to take it. As with all good things, there can be too much speculation.

The precise effects of the infusion of speculative money into the oil and gas markets cannot be determined, but they are clearly significant. First, the amounts involved are enormous. Financial institutions, hedge funds, pension funds, and other investors have put billions into energy commodities markets. One of the more important economists in the field has calculated that the amount of money invested in commodity index funds "jumped from $15 billion in 2003 to $56 billion in 2004 and on to $80 billion today."

Needless to say, these institutions have no use for petroleum other than to sell it to someone else. Second, by all accounts, the traders are doing extremely well. Out front is T. Boone Pickens who is reported to have made around $1.5 billion last year. While not in that league, there is a long list of others who have made millions.

What we are left with is the possibility that out of the $70 price for a barrel of oil about $20 can be accounted for by speculation. This brings us to the most important part of the report: We need to know more.

Until quite recently trading on futures markets was regulated by the CFTC. Trades on regulated markets are subject to reporting requirements. Traders are required to report large trades to the CFTC, which has the responsibility of limiting excessive speculation. However, concurrent with the dramatic increase in speculative trading of energy futures, there has been a shift of this trading to unregulated commodity exchanges.

Essentially this shift is the result of an exemption written into the Commodity Futures Modernization Act of 2000 at the behest of Enron. Perhaps more important is the announcement by the Intercontinental Exchange that it would permit traders to use its terminals in the United States to trade futures contracts for crude oil, gasoline, and heating oil produced and delivered in the U.S. on its ICE Futures exchange in London.

In effect, American traders can completely circumvent all U.S. regulation, including reporting requirements, by simply routing their transactions through London. It is important to understand that the CFTC's large trader reporting requirement is the Commission's primary tool for preventing market manipulation. The recent charges against BP for manipulation of the propane market appears to involve activity on the over-the-counter-market. Apparently it was part of BP's strategy to use the unregulated market, where it could avoid making reports and could expect no surveillance.

Finally, lurking in the report is more than a hint that all this speculation in ever-rising oil prices could come to a bad end. The report quotes one oil trader, "At some point, this oversupplied market has to begin to break down this house of cards which is dominated by speculative entities, and when those entities decide to start liquidating their futures positions in crude and gas, look out below."

Henry M. Banta is a partner in the Washington, DC, law firm of Lobel, Novins & Lamont.
E-mail: henrybanta@aol.com